Tax-loss harvesting, also known as tax-loss selling, is a powerful strategy that can enhance the tax efficiency of your investment gains. This strategy involves selling underperforming investments and realizing a capital loss that can then be used to offset capital gains from other investments.
As a brief refresher:
- Capital gains are triggered when you sell an investment for more than the price you purchased it for (profit).
- Capital gains are triggered when you sell an investment for less than the price you purchased it for (loss).
- Capital gains are included in your annual taxable income and taxed at your marginal tax rate. For individuals, the inclusion rate is 50% for capital gains up to $250,000 and 66.6% for the remaining amount above this threshold.
While the idea of intentionally selling a losing investment may seem counterintuitive, this can be a smart way to reduce your tax liability or in other words, the amount of taxes you owe.
Tax-Loss Harvesting Example
Suppose you purchase 100 shares of XYZ at $10-per-share, for a total of $1,000. Over time, the price of XYZ falls to $6-per share, and your 100 shares are now worth $600. You choose to sell all XYZ shares for $600 and realize a loss of $400 on your initial investment. This loss is considered a capital loss and can be applied against any capital gains realized in the same tax year, thus reducing your total taxable capital gains.
Say you also realize $2,000 in capital gains in that same tax year. Your $400 loss can be used to offset part of those gains. After netting the capital gains and losses, you would pay taxes on $800 of your earnings at the 50% inclusion rate for capital gains ($2,000 – $400 = $1,600 * 50%).
Had you not used tax-loss harvesting, you would report $2,000 in capital gains and pay taxes on $1,000 (50% of $2,000). In this example, you are reducing your reported capital gains by 20% using tax-loss harvesting.
Key Considerations
The above example provides a simplified illustration of tax-loss harvesting. In reality, most investors hold diversified portfolios with investments across account types, asset classes and sectors that require regular rebalancing and are subject to different tax treatments. This interplay can make tax-loss harvesting even more nuanced. Several other considerations should be kept in mind when tax-loss harvesting.
1. Eligible Investments
Tax-loss harvesting only applies to realized capital gains and losses in non-registered accounts. Losses within registered accounts, such as RRSPs and TFSAs, cannot be used for tax purposes, as gains and losses within these accounts are not taxed until withdrawals are made. In other words, capital losses in registered accounts cannot offset capital gains in non-registered accounts.
Alternative and private investments, such as private equity or private real estate, may also benefit from tax-loss harvesting, though challenges like liquidity, valuation, transaction costs, lock-up periods and differing tax treatments must be carefully considered.
2. Superficial Loss Rule
The Superficial Loss Rule prohibits you from claiming a tax deduction on a capital loss if you repurchase the same or identical investment within 30 days before or after the sale.
The Superficial Loss Rule is an important consideration when tax-loss harvesting, but with careful planning, you can sidestep it using strategies such as waiting 31 days before repurchasing the same investment or buying a similar but not identical investment.
3. Carry-Back & Carry-Forward Rules
Capital losses can be carried back three years or forward indefinitely to offset capital gains in those years.
For example, if you realize a capital loss in 2024, you could carry that loss back to offset any capital gains from 2021, 2022 or 2023 by filing a T1 Adjustment Request. If the loss isn’t used in the current year or carried back, it can be carried forward to offset capital gains in future years.
Final Thoughts
Tax-loss harvesting is often associated with year-end tax planning, as investors try to reduce their tax liability for the current year. However, it can be done throughout the year, especially if there are market fluctuations that create opportunities for harvesting losses. It’s important to work with an experienced financial professional like a Rothenberg Wealth Management Advisor to assess whether you can benefit from tax-loss harvesting and how you can implement this strategy to maximize your portfolio’s tax efficiency and reduce the amount of taxes owed.
